If a taxpayer is a trader and properly elects under IRC §475(f) to use the mark to market treatment, the gains and losses from the trading activity are treated as ordinary, rather than capital, gains and losses. Of particular significance is that losses in excess of gains will not be subject to a $3,000 annual limitation.

IRC §475(f)(1) allows an individual involved in the trade or business of trading securities to elect to apply the mark-to-market method generally outlined in IRC §475 to trading income from the trade or business. Under that method any trading securities held at the end of the tax year will be treated as if sold on that day, recognizing the gain or loss. And, as was noted above, that gain or loss or treated as ordinary in nature and not capital.

Conversely, if the trader does not make that election no deemed sale will take place, but the gains and losses will be capital in nature. Since a trade, by definition, is looking to take advantage of very short term price swings the capital gains and losses generated will virtually always be short term in nature.

Thus the election will not generally cause the taxpayer to “give up” the lower capital gain tax rate (since the gains generally would not qualify for the lower rate). Nor does the “forced sale” often create a major issue, as traders most often open and close the day holding only cash. Thus the practical effect of the election is to allow for deduction of losses in excess of $3,000—and even using such losses to create a net operating loss.

However the election is subject to strict procedural requirements. Revenue Procedure 99-17 provides the procedures that must be followed to make this election. Generally the revenue procedure requires:

An election is to be filed with the IRS on before the due date (without regard to extensions) for the year period to the year the election is to take effect

If the election would result in a change in the method of accounting (as it almost always would), the taxpayer must attach a Form 3115 to a timely filed tax return filed for the year of change, as well as filing a copy of the Form 3115 as required by the automatic change revenue procedure currently in effect.

While the year before the Tax Court was 2007, the taxpayer claimed he had make the mark to market election for 2003. However the taxpayer did not have a copy of the election that he claimed he filed with the IRS, he also lacked a copy of a Form 3115 mailed separately to the IRS and his 2003 return, filed late in 2005, did not have a copy of the Form 3115, only a notation that the taxpayer had make a §475(f) election.

The IRS noted that it had no copy of a Form 3115 in its files, though it admitted that in some years not all Form 3115s were actually entered in its database.

The Tax Court found that the taxpayer filed to show that the requirements to make the election under Revenue Procedure 99-17 had been met, and thus he was not eligible to use the mark-to-market method in 2007.

The taxpayer argued that if he hadn’t actually literally complied with the requirements of Revenue Procedure 99-17 he should be given credit for substantial compliance with its requirements and thus allowed to use the mark-to-market method in 2007.

The Tax Court begins by noting that:

The substantial compliance doctrine has no place in determining whether a timely section 475 (f) election has been made. Kohli v. Commissioner, T.C. Memo. 2009-287. Rev. Proc. 99-17, supra, fixes a deadline by which the election must be made and the requirements for the election. Because petitioner failed to comply with the requirements of Rev. Proc. 99-17, he did not make an effective mark-to-market election in 2003.

Or, put more simply, as noted above this election requires strict adherence to the rules.

There are a couple of key issues advisers should note in this case. First, advisers need to remember that if a taxpayer is a trader (which is, in and of itself, not a simple definition to meet), a mark-to-market election generally must be made by April 15 of the year the taxpayer begins operating as a trader. Thus if the adviser becomes aware that a client is considering entering trading the adviser needs to explain the special problem of making this election in a timely fashion.

A more general issue to note is that the Tax Court required the taxpayer to show that an election had been made in an earlier year, as well as that a Form 3115 had been submitted—even when the IRS admitted that they at times filed to record such items. The burden remains on the taxpayer for as long as the election is in place to be able to demonstrate that the original election had been properly made, no matter how many years earlier that election may have been filed.